Investment Risks in the Initial Coin Offering Sphere

There is an enormous amount of speculation currently occurring in the initial coin offering (“ICO”) sphere, fueled by the rapid increase in the value of bitcoin and other cryptocurrencies. Cryptocurrency is a digital asset that uses cryptology to make transactions secure, and is decentralized in that its creation of new units of currency is fixed via an algorithm, and outside the control of central banks. As such, cryptocurrency currently acts as a derivative to world money supply and debt, with its value increasing in tandem with money supply, demand, and increased pressure from the no-arbitrage rule of functional equivalence. This exchange applies as long as a counterparty accepts the given cryptocurrency as a store of value and medium of exchange.

Cryptocurrencies have appreciated rapidly largely due to the worldwide low interest rate environment created by central banking policy. Many safe fixed income investments offer negative real rates of return after taxes and inflation are accounted for, generating a massive “search for yield” into alternative investment classes. This search includes hard assets such as commodities and real estate, and increasingly exotic assets such as ICOs. With the growth of ICOs, there is a tangent proliferation of fraudulent or risky investment schemes that seek to capitalize on increased ICO demand through complex capital structures and equity issuance. Given the limited regulation and inherent difficulties in insuring or protecting risk in this sphere, it is important investors be wary.

Apple Pay, and PayPal are sophisticated versions of digital assets, however the technical innovation with cryptocurrency is the use of a decentralized ledger distributed among network nodes, as opposed to a centralized ledger used by banks. As such, Apple Pay and Paypal are simply digital versions of a specific fiat currency such as USD, and are not a separate asset class. Each node in a cryptocurrency network has a full copy of the entire distributed network, meaning corruption of the system would necessitate corruption of all nodes simultaneously, which according to experts is nearly mathematically impossible from a code breaking standpoint. The key innovation difference between digital fiat and algorithmically derived cryptocurrencies is that cryptocurrencies can be created with a fixed supply set by the algorithm, as with Bitcoin which is capped at 21 million coins. There are currently approximately 16,519,00 coins in circulation, and with supply fixed and demand growing, some speculators think the price will continue to rise dramatically.

Cryptocurrency proponents use the following calculation when illustrating appreciation possibilities in cryptocurrency sphere: The US supply of money, known as M2, is currently $13.12 trillion. The market capitalization of bitcoin is currently $67.2 billion, and under the no-arbitrage rule, assuming bitcoin is the functional equivalent of fiat money, one could approximate a 194x return as the bitcoin market cap approaches M2. The possibility of wide acceptance, fixed supply, increasing demand, and appreciation due to no-arbitrage rule, has created this cryptocurrency frenzy in 2017.

However, most cryptocurrencies are uninsurable, highly speculative, and very risky. There is an increasing trend in the creation of Over the Counter (“OTC”) stock offerings in companies that buy holdings of Bitcoin and then issue shares. The reasoning behind these offerings is that they give investors cryptocurrency exposure but with access through the equity market. However, the danger here is two-fold: investors are exposed both to the risk and volatility of the cryptocurrency holdings, as well as the counterparty risk of the entity they are buying shares in that purports to hold cryptocurrency holdings. While some of these investment trusts are large and have audited financials with large amounts of financial backing such as Grayscale Bitcoin Investment Trust (“GBTC”), they trade at valuations far higher than the net asset value (“NAV”). What this ratio means is that the investment trust may own $100 million worth of bitcoin, however its shares trade at a price that collectively give the investment trust a valuation of $190 million, meaning it trades at a 90% premium to the NAV. Some proponents argue this premium is justified by the ease of access provided by equity market, and the premium to NAV is essentially a liquidity/non-friction premium. However, GBTC according to its 10K filings was unable to obtain insurance on any of its holdings, meaning investors own shares at a 90% premium to the NAV in a company in which none of the holdings are insured. Even in the face of these risks, GBTC is considered one of the most liquid and trustworthy of OTC cryptocurrency investments. Many others have received notices by the Securities and Exchange Commission (“SEC”) requesting justification of their holdings and structure in relation to share issuance.

Speculative investments in the cryptocurrency sphere are a popular aspect of the 2017 capital markets, and the securitization and trading of cryptocurrency investment companies is a new development. If your investment advisor has placed your account in cryptocurrencies and you have suffered losses, or if you are initiating a cryptocurrency investment trust, you should seek council from securities lawyers. Lax & Neville LLP has nationally represented small broker-dealers, financial services professionals, and securities industry companies in regulatory matters and securities-related and commercial litigation. Please contact our team of attorneys for a consultation at (212) 696-1999.